32 - Roger Farmer on the Natural Rate of Unemployment Hypothesis and Prosperity for All

Episode Summary

Executive Summary: Roger Farmer argues that macroeconomics should move beyond the natural-rate/New Keynesian framework toward a multiple-equilibria view driven by incomplete labor and financial markets, beliefs, and animal spirits. He proposes targeting a broad asset-price index, alongside inflation, to stabilize the economy and prevent crises.

Main Topics: Farmer’s path into macroeconomics (Priority: 2/5): Farmer explains how early exposure to economics through a family connection led him from econometrics into macro, and how strong faculty in macro at Western Ontario shaped his field choice. Critique of the natural rate hypothesis (Priority: 5/5): He challenges the idea that unemployment returns to a unique natural rate, citing long-run data that look more horizontal than vertical and arguing for multiple steady-state unemployment equilibria. Limits of New Keynesian macroeconomics (Priority: 5/5): Farmer criticizes the baseline New Keynesian model as relying on implausibly sticky prices, persistent inflation, no unemployment, small welfare costs of cycles, and inability to explain bubbles and crashes. Incomplete labor markets and search frictions (Priority: 4/5): He reframes unemployment through search theory, emphasizing missing markets and missing price signals in matching workers and jobs, rather than simply wage stickiness. Incomplete financial markets and intergenerational insurance (Priority: 5/5): Farmer argues that unborn generations cannot trade in financial markets, so complete-market models miss the inability to insure against future crises and volatility. Belief functions, animal spirits, and multiple equilibria (Priority: 5/5): He proposes belief functions as a formal way to model expectations and confidence, making beliefs a fundamental input that can select among multiple equilibria and generate crisis dynamics. Policy: asset-price targeting and stabilization (Priority: 5/5): Farmer recommends using the central bank or treasury to target a broad ETF-based asset-price index to stabilize beliefs and asset values, while also maintaining an inflation target.

Key Arguments: The natural rate hypothesis is empirically weak because long-horizon unemployment and inflation data do not support a single vertical equilibrium; macro can settle at multiple unemployment rates. Modern New Keynesian models are patched with ad hoc additions and fail key tests, so they resemble a degenerating research program rather than a progressive one. Unemployment reflects incomplete labor markets: job matching is a technology, but the absence of a market for matching services prevents price signals from coordinating outcomes efficiently. Financial crises matter because future generations cannot insure themselves against bad states; complete-markets models ignore this intergenerational incompleteness. Beliefs are not just noise; they are a productive fundamental that can shift equilibrium outcomes and trigger confidence crashes. Rational expectations can remain useful, but only within a multiple-equilibria framework where beliefs determine which equilibrium is realized. A broad government backstop via ETF price targeting could stabilize asset values and prevent self-reinforcing downturns without micromanaging individual firms. Inflation targeting and asset-price targeting can coexist because the economy may have multiple real and nominal steady states rather than one natural rate tying them together.

Data Points: Undergraduate average window: 10 years (120 months) - Farmer used 10-year monthly averages of unemployment and inflation to test the natural rate hypothesis. Search model example: 10,000 jobs/month; 100,000 vacancies and 50,000 searchers - Illustrative point on the Beveridge curve as a matching technology iso-quant. Alternative search example: 100,000 searchers and 50,000 jobs - Another point on the same Beveridge curve iso-quant. Inflation target: 2% - Farmer references restoring a 2% inflation target, potentially by raising interest rates to 2%. Time period reference: 1929 vs. 1960s - Used as contrasting states in the insurance/asset-market example to illustrate intergenerational hedging. High unemployment example: 25% - Used to illustrate that, under a windy-boat view, unemployment could settle at very high levels. Alternative unemployment example: 5% - Used to illustrate another possible steady-state unemployment equilibrium under the multiple-equilibria view. Crisis reference: 2008 financial crisis - Used as an example of a confidence crash and asset-price collapse followed by recession.

Pivotal Quotes: "I found in data was much close to horizontal than vertical." — Roger Farmer: Explaining why his long-run unemployment-inflation graph led him to doubt the natural rate hypothesis. "We should really be thinking about notions of multiple steady state equilibria to think about macroeconomics as opposed to sticky prices." — Roger Farmer: Summarizing the core alternative to mainstream New Keynesian macro. "The economy is like a sailboat on the ocean with a broken rudder." — Roger Farmer: Contrasting Keynesian multiple-equilibria dynamics with the standard rocking-horse metaphor.

Implications: Listeners should expect a macro framework where beliefs and asset prices matter as much as output and inflation. For policy, Farmer’s approach implies active stabilization of financial-market expectations, not just conventional interest-rate management.